General Motors’ Stock Buyback Follows a Worrying Trend

General Motors’ announcement that it will buy back $5 billion worth of stock raises the question of whether the stock buyback has turned into a shareholder activist shakedown.

G.M. did not open its coffers willingly. Harry J. Wilson, a former member of the auto industry crisis task force led by Steven Rattner, gave it a helping hand. A few weeks ago, Mr. Wilson announced a campaign to press G.M. to buy back $8 billion worth of stock, leading four hedge funds with a total stake of about 2 percent in the automaker. As part of this, Mr. Wilson was nominated to run for a board seat.

Because G.M. was bankrupt only a few years ago, it seems a bit foolhardy for the company to willingly part with billions of dollars of hard-earned cash. But in a world where stock buybacks and shareholder activism are all the rage, it makes perfect sense on paper, if not in reality.

As activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.

According to a report by the law firm Schulte Roth & Zabel, as recently as 2013, 13 percent of activist campaigns sought a cash return. The call to return cash is based on the fact that United States companies are extraordinarily profitable and are building cash mountains when interest rates are at record lows. With limited ability to earn decent returns, activists have pushed hard for companies to return the cash to shareholders.

Companies that want to return money to shareholders have a choice: They can pay a dividend or buy back shares. In the former case, the calculus is easy. Assuming that there are no big tax issues, a dividend is just a return of cash to shareholders. But buybacks do more by taking shares out of the market. A buyback does not create wealth; theoretically, the cash disappears with the shares. But it does increase earnings per share and usually lifts the stock price, giving the remaining shareholders a bigger piece of the upside.

Buybacks make sense if a company’s management thinks its shares are underpriced and thus thinks it is getting a bargain. The peril in any stock repurchase, of course, is that the company pays too much.

But when have executives ever thought their company’s stock was overpriced? So companies choose the buyback. According to a highly influential article criticizing buybacks in The Harvard Business Review by William Lazonick, 54 percent of earnings — $2.4 trillion — went to stock buybacks and 37 percent went to dividends for the 449 companies in the Standard & Poor’s 500-stock index that were publicly listed from 2003 to 2012. According to a Barclays report, stock buybacks totaled $535 billion for the year that ended September 2014.

But returning cash isn’t all that a buyback or even a dividend does. The core idea behind a share repurchase is that it will make the company more disciplined.

Think about a world where you can have all the doughnuts you want. You just might eat a few too many. If a company like G.M. has an extra $5 billion sitting around, the thinking goes, it might decide not to invest wisely in the business or make smart acquisitions but instead simply use the cash less efficiently, like paying higher executive salaries.

Mr. Wilson’s argument for a large stock buyback was based on this conceit. In an interview with CNBC, he said that in the auto industry, when “times are good, they overinvest and make bad acquisitions, they overspend.”

But buybacks can leave a company without needed cash. G.M. had many buybacks before the financial crisis, totaling $20.4 billion from 1986 to 2002. It certainly could have used the cash then. Mr. Wilson is aware of this issue and stated in the CNBC interview, “We have always agreed that the company should have enough cushion” but that it was “enormous.”

And there is always the risk of overpaying for shares, especially now. With zero-interest rates, the stock market is bound to be high, and buying now may not make sense. In fact, most buybacks these days tend to destroy value because of their inflated prices

Other problems can arise with buybacks. Mr. Lazonick has argued that repurchases leave little for “productive investment” and should be banned. The Economist called them “corporate cocaine” and cautioned that some companies may be borrowing too much to pay for them. Companies may also end up using buybacks to manage expectations for earnings per share, especially when large numbers of stock options are outstanding.

Still, the noted valuation expert Aswath Damodaran asserts that much good could come from share buybacks and that banning or regulating buybacks falls “squarely in the feel-good but do-bad economic policy realm.”

The vibrant debate shows the pros and cons of share repurchases, but G.M. was apparently unswayed by the cons.

The automaker quickly capitulated to the $5 billion buyback, with Mr. Wilson agreeing to withdraw his candidacy for the board, despite disagreement from another large shareholder, Warren E. Buffett. In an interview with CNBC, he said, “I think the idea of trying to do something now that gets a little pop in the stock should not be on” G.M.’s agenda.

At the end of the day, G.M. decided it was better to retreat than to fight. The activists know that the companies are feeling defensive. Even though Mr. Wilson’s group owned just 2 percent of the company, a contest would have been difficult and expensive. The $5 billion turned out to be the cost of doing business. As Marketplace put it, “Please shut up and here’s some money.”

Going forward, G.M. will aim to keep $20 billion in cash on its balance sheet and return free cash flow beyond that to shareholders. It had built up about $25 billion in cash as its sales and profits rebounded after its 2009 government-led bankruptcy.

The G.M. episode may signal a turning point. In good times, it is easy to get too comfortable. Technology companies like Google and Microsoft are stockpiling foreign cash. Others are racing to buy back shares at high valuations. But the good times inevitably end, this time most likely led by the activist stampede.

The haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash out companies and shareholders.

Steven Davidoff Solomon is a professor of law at the University of California, Berkeley. His columns can be found at nytimes.com/dealbook. Follow @StevenDavidoff on Twitter.

A version of this article appears in print on , on Page B5 of the New York edition with the headline: General Motors’ Stock Buyback Follows a Worrying Trend. Order Reprints | Today’s Paper | Subscribe